Debt consolidation gathers debt from multiple sources and puts it in one place, which simplifies paying off what you owe. Consolidation can also allow you to reduce the interest rate or total amount of your debt.
Most of us manage many forms of debt simultaneously, keeping track of due dates and balancing interest rates to avoid late fees or a bruised credit score. But one lump sum means one lender, one due date, one interest rate, and one set of login credentials. It can be a strategic personal finance move in the long run — as long as it’s done right.
Here’s everything you need to know about debt consolidation and whether it’s right for you.
What is debt consolidation?
Debt consolidation is an umbrella term for programs that turn multiple debts into a single, manageable one. This can be done through a loan, or without one (more later on the various options).
Regardless of the particular solution you choose, the goal is for the ‘new’ debt to have a lower interest rate than what you’re used to. In most cases, the total amount of debt owed stays the same, but the single recurring payment is smaller than your old bills combined, making it easier to manage.
Debt consolidation is a great option for someone who has multiple high-interest debts that they’re having trouble staying up to date on paying. But it can do more harm than good if the debtor isn’t fully committed to the plan, or if the plan itself isn’t the right fit.
Over time, the right plan can help you manage your debt, increase cash flow, and improve the score on your credit report — which in turn can lead to a higher likelihood of approvals on future debt.
How Does Debt Consolidation Work?
Depending on your goal, you can develop a debt consolidation plan through a financial institution, a credit counseling agency, or a debt relief company.
To know where to start, you need to evaluate the debt you’re working with and the terms you’re willing to agree to. These are the things to consider. It helps if you collect any related paperwork along the way:
- Take stock of the debt you’d like to consolidate. Determine which debts your planning to address, and how much you currently owe on each. You’ll find that some debts, such as those on credit cards, can more easily be rolled into a single solution, while others, such as personal loans, may need to be addressed separately.
- Obtain your credit score. This step helps you know the range of options you enjoy. If the score on your credit report is 750 or higher, for example, you’re good to go: You can probably get a loan to cover your debt, provided you meet the other loan requirements, and at a low interest rate. If your credit score is below 650, you’ll likely need to take a different route completely, or hold off on consolidation until you can take steps to increase your score. Somewhere in between? You might be able to get a loan, but it could be for less or at a less favorable rate than if your score was optimal. Some other options could be feasible, though, including getting a balance transfer credit card that combines your card debts into a single low-interest payment.
- Decide what the terms on your new account should be. Find your weighted average interest rate — different from a simple average in that it gives preferential treatment to your bigger debts. To calculate, add up the debt balances you wish to consolidate, and then add up the interest paid, in dollars, on each of these balances. Make sure you use the monthly interest rate (for an APR, that means dividing the percent by 12). Divide the total debt by the total interest paid, and multiply by 100 to turn it into a percent. This is the monthly interest rate you want to beat in any consolidated-debt solution.
- Determine how much you’re willing to pay every month. Come up with a monthly payment that’s reasonable for the long run, based on your current household budget and your spending habits. Remember that these repayment programs might come with initial costs and additional monthly payments — for a debt management program, the details of which we’ll get into, you might need an extra $25 a month. When you go to a lender or a debt relief company with the amount you decide you can afford to spend every month, be clear that it should also account for these extra fees.
Best ways to consolidate debt
Your options to roll debts together into a consolidated solution depends not only on your eligibility for credit, but on the kinds of debt you hold.
Secured debt is debt that, like a mortgage or auto loan, is backed by collateral like a house or a car. Such debts require special care when it comes to debt consolidation. The collateral makes it so they can’t be combined with other types of debt — only with each other — and so they require a dedicated solution, such as a mortgage refinancing for one or more mortgages on your house.
Unsecured debt has no such asset tied to it (think: credit cards, student loans, or medical bills). These might be rolled into a single debt (and payment) in the following ways:
Debt consolidation loan
This is a loan large enough to pay off a multitude of unsecured debts.
You can get such a loan through a bank, credit card company, credit union, or online lender. And if you you can’t get the repayment terms you’re hoping for, you might turn to an online service that offers peer-to-peer lending.
Some lenders have restrictions about the types of debts you can combine. So if you’re interested in a repayment plan for a smorgasbord of debt, make sure you find a company or service that allows that.
When it comes to a loan of this size, the ideal candidate has a steady flow of income, a comfortable amount in savings, a history of paying off debt on time, and a solid credit score.
You may see this listed as a debt consolidation option. This is mostly a matter of semantics. A debt consolidation loan is a personal loan, just one that is used exclusively to pay down debt. Personal loans can, of course, also be for emergency expenses or to pay off bills before they become debt.
Debt management program
This is a repayment program that doesn’t involve a loan.
For an initial fee and a monthly payment, you can sign up for a debt management program (DMP) through a credit counseling agency. The agency — usually a nonprofit organization — will work with your existing lenders to lower your interest rates. Your monthly payment will go to the agency, which then distributes it accordingly.
This is a good alternative if your credit score is just barely too low to help you get a debt consolidation loan or get the interest rate you were hoping for (your weighted average interest rate, as detailed in item #3 above). The interest rates on a DMP are usually low enough that, even with the additional fees, your total monthly cost should be lower than your total repayment with a debt consolidation loan.
So why shouldn’t everyone get a DMP rather than a loan? Because the program comes with strings. You typically need to sign on for three to five years, during which time you’ll be required to close any credit cards whose debts you’re consolidating, and won’t be permitted to open any new lines of credit. Even credit cards that aren’t part of the program might be monitored by creditors, and their use limited. If your monthly payment is late, or you otherwise break one of the program’s conditions, or if you simply decide the arrangement isn’t for you, you might automatically lose any concessions granted to you through the DMP.
Balance transfer credit card
If credit cards are the only debt you’re seeking to consolidate, a balance transfer credit card is the best option. It allows you to move the balance from multiple cards to a single card with a lower annual percentage rate (APR).
This transfer usually can’t be made to another card issued by the same bank, so you’ll need to choose one from another card issuer. Most balance transfer cards have an interest-free introductory rate of at least six months; better cards offer a longer period, and those might require a better credit score to qualify.
After the interest-free period expires, the rate kicks up to anywhere from 13% to 25%, which — once again — depends on your credit score. So the goal is to pay off the debt before the introductory rate expires. There’s also usually a transfer fee of up to 5%, but it may be waived to entice people switching over.
An irony to these cards is that those who most need one may not be able to get the best ones with the longest 0% periods, because they lack the needed credit score. A survey by Money and Morning Consult found that people with a credit score of between 620 and 659, which is only mediocre, were the most likely subgroup to be paying interest on their credit cards. (They were also twice as likely to say they were “very stressed” about their credit card debt than the average American).
Direct consolidation loan
This option applies only for education loans, and is a fixed-rate federal loan that you can apply for via the U.S. Department of Education. The program lets you combine student loans “at no cost to you,” the department says, and uses the weighted average of your current loans to determine your interest rate.
Home equity loan
One of the riskier options, a HELOC — a Home Equity Line of Credit — involves using your home as collateral to pay off your debt, thus putting your house on the line for the loan. Home equity is the house’s current value minus what you still owe, and banks will let you borrow up to 80% of that amount. The advantage is that the interest rate on a home equity loan can be a half to a third that of credit cards. The disadvantage is more extreme: If you don’t make your payments on time, you’re at risk of foreclosure.
Another risky option is to take out a loan against your retirement or savings account. It’s tempting because it’s a sure thing — this is your money, which means there’s no credit check to clear, and any interest paid goes right back to your account. And it can be an appropriate solution, for a serious and very short term need. A 401(k) loan will deplete a crucial investment that you can’t quickly replenish. And you’ll be taxed at your current rate for dipping into it if it’s not paid back in a timely manner.
Also technically a debt consolidation program, debt settlement involves hiring a debt relief company to negotiate your debts down to as much as 50% of what you owe.
But this option should be considered only if all others have failed to yield enough to cover your debts. A debt settlement will stay on your credit report for seven years and damage your credit score. You could also be on the hook to pay taxes on the difference between what you originally owed and the reduced amount you actually paid. For these reasons, make this move only as a last resort — say, if you’re at risk of filing for bankruptcy.
Other Things to Consider
Check the reputation of any company you don’t know. There are plenty of companies that exist just to take advantage of people struggling with debt — you want to avoid these companies at all costs. For a loan or a balance transfer credit card, use a licensed financial institution and a name you trust. If you decide a debt management plan or a debt settlement is right for you, vet the debt relief company or agency in question through the Better Business Bureau to see if any complaints have been made against them.
The score on your credit report may drop, at least for a while. Dealing with your debt is likely to have consequences for your credit history. A debt consolidation loan, for example, replaces debts that have a payment history with a new loan that doesn’t. And a debt management program generally requires that you stop using your credit cards for a little while. Both of these moves can hinder your score, at least temporarily.
Your credit score will inch its way back up, assuming you make your payments on time. If you were struggling before to submit payments on time, your score might even be better than ever. But such timeliness is crucial. You should avoid debt consolidation altogether if there’s a chance you won’t be able to make the payments.
Relatedly, don’t schedule a debt consolidation program if you have imminent plans for a big purchase, a mortgage refinance, or anything else that involves pulling your credit report as part of the application process. These both depend on a good credit score and temporarily lower your credit score.
Lastly, ask about future interest rates. If you’re dealing with a new interest rate that isn’t fixed, be sure to talk to the provider about the possibility that it might increase down the line, and then fight that possibility or budget accordingly. And no matter what, read the fine print. Every last tiny line of it.